US stocks suffered their biggest daily loss since the US election yesterday, how serious is this?
What goes up must come down, or so said Isaac. But he was not entirely correct. We now know that if you can find your way out of the Earth’s atmosphere, you can stay up for as long as you like.
Whenever markets soar, we are told that they will come back down again – but that is only right if you believe in some kind of Armageddon. Over time, stocks markets track the economy, and the economy is much bigger today than it was, and thus rising stock markets do not have to fall.
No, what goes up only comes down if it stays within the atmosphere.
As for stock markets, they can rise, and rise again, but only if the economy is doing the same, and is likely to continue doing the same.
Ever since the US election, US stocks have been hitting highs with such regularity that it is no longer news. Last night, after a day of heavy losses, the Dow closed at 20,688, to put that in context, on November 7th, the day before the US election, the index closed at 18,259. The index passed 16,000 in February 2014.
So, for US stocks it has been boom times.
Some look at the fundamentals, they look at the Shiller CAPE, for example, which compares valuations with average earnings over the previous ten years, and say the index is grossly overvalued.
They may be right, but just bear in mind that the last ten years has been awful for the economy, earnings have been through a particularly bad period.
Economic history tells us that economies recover, and downturns are eventually followed by periods of above average growth. If this holds true this time around, then the US stock valuations are justified.
And the news on the US economy has been good of late.
So why did markets fall yesterday? (21st March).
The Dow lost just over 230 points. There are two possible explanations.
One is that the markets had got a bit ahead of themselves, and needed to cool down a bit. We know that bull markets, when stocks surge over a period of time, are often punctuated with quite large falls – but then make-up for the lost ground pretty quickly.
Sometimes, however, a fall is sign of bigger falls to follow.
What did yesterdays’ fall mean?
The markets are not taking into account some of the big risks with the global economy. Suppose Marine Le Pen wins in France and we see the breakup of the euro, this may spark off a banking crisis comparable to what we saw in 2008.
House prices look frothy in some countries – Sweden and Australia, for example, and maybe in some cities, such as London. If that frothiness turns into a housing crash, the fallout could be bad.
Household debt across much of the world is close to crisis making levels.
And we don’t know for sure how high interest rates will rise before the economic cycle is over. Yesterday’s news on UK inflation – up to 2.3 per cent – shows that there is lots or room for surprises.
If rates do go up faster than expected, then this could hit housing markets, leading to sharp falls, while higher rates make household debt less affordable, just at a time when falling house prices leave households with falling net wealth.
Combine that with a break-up in the euro and we may face a perfect storm.
But right now, the momentum is pushing in the other direction. The global economy looks quite good.
Yesterday’s fall does not feel like the start of something bigger.
But that does not mean, that something bigger might not happen, eventually.